Inquiry Into Commissions at Bayou

By GRETCHEN MORGENSON; Jenny Anderson contributed reporting for this article.

Published: September 1, 2005

Over the last two and a half years, Bayou Securities, the brokerage unit of the Bayou Group, the Connecticut hedge fund firm at the center of a growing investigation, generated $51.5 million in revenue executing trades for its four affiliated hedge funds, according to two people who have seen financial statements the firm filed with its regulators.

Because Samuel Israel III is sole owner of Bayou Securities and all of the Bayou funds, the revenues generated by the brokerage firm may have supplemented the millions of dollars Mr. Israel took in incentive fees based on the hedge funds' reported gains in recent years. Commission revenues of $51.5 million over two and a half years seem excessive for a small firm like Bayou, fund specialists said, even if its funds made rapid-fire trades each day.

Officials at the Federal Bureau of Investigation, the United States attorney's office and the Connecticut state banking department are trying to sort through what is left of the Bayou Group, which claimed to have $411 million under management at the end of 2004.

The Bayou Group's principals said they were closing the firm in July and would return investors' funds in August. But just as the money was supposed to have arrived, the Bayou Group's principals stopped communicating with investors, leaving them largely in the dark about what, if any, money remains at the company.

Lawyers for Mr. Israel and Bayou, meanwhile, quit representing him and the firm yesterday in his claim to gain control of $100 million that was seized in May by Arizona authorities. Scott A. Rose and Jeffrey B. Smith of the Cavanagh Law Firm in Phoenix had been arguing that the money belonged to Bayou, but they filed a motion in Arizona Superior Court yesterday to withdraw their representation of Bayou because they could not locate Mr. Israel.

The lawyers also said that Bayou had neither paid them nor provided information needed to pursue the case.

The apparently lucrative relationship that Bayou Securities had with the Bayou hedge funds is likely to be of interest to investigators trying to determine where investors' money has gone.

Marketing materials provided by the Bayou Group to potential investors acknowledged the potential for conflicts that existed in the funds' use of Bayou Securities to execute trades. The firm ''is entitled to receive commissions on those trades which will be at rates comparable to those charged by other brokers but may not be at the best possible rates otherwise available'' to the funds, the materials noted.

But other Bayou sales documents contended that using an affiliated brokerage unit to conduct the funds' transactions helped keep trading costs down for the Bayou funds.

And some Bayou investors said they took comfort in knowing that their hedge funds' trades were executed by Bayou Securities, a firm that is registered with securities regulators and subject to routine audits and oversight. While the trading revenue numbers appear high, regulators may not have been concerned because they had no oversight of the hedge funds.

In 2003, Bayou Securities generated $29 million in revenue trading for the Bayou funds, according to the people who reviewed the regulatory filings. That is equal to 9.6 percent of the funds' total capital at the end of that year. In 2004, revenue at Bayou Securities declined to $16 million, or 4 percent of the funds' capital. In the first six months of 2005, trading revenue was $6.5 million.

It is unclear how much of this revenue, if any, Mr. Israel has taken out of Bayou Securities, a private company that does not file public financial statements. Last year, Bayou executives took $10.8 million in incentive fees from the funds, according to documents given to investors.

The commission figures disclosed to regulators in recent years by Bayou Securities also appear to contradict those reported by the Bayou funds to its investors. For example, in 2004, Bayou's investors were told that the hedge funds paid approximately $8 million in commissions to the brokerage unit affiliate, exactly half the $16 million the brokerage unit told regulators it had earned.

Any discrepancy between commission figures Bayou supplied to regulators and those that Bayou told investors about could reflect commission rebates provided to Bayou Securities by unaffiliated brokers conducting trades for the Bayou funds. Brokerage firms executing trades for active investors, as Mr. Israel appeared to be, often give rebates to help defray these customers' trading costs. If that were the case, however, the rebates would have belonged to Bayou's investors, not to Mr. Israel.

But another explanation for a discrepancy between commission figures disclosed to investors and those given to regulators may be that Bayou's chief financial officer, Dan Marino, hoped to play down for his investors how lucrative the relationship was between the affiliates. Bayou's disclosures to investors about commissions Bayou Securities earned were made in financial statements that may be questionable because they were vetted not by an independent auditor but by Richmond-Fairfield Associates, whose registered agent is Mr. Marino.

The fact that Mr. Israel and his colleagues charged no management fee to Bayou investors sets it apart from most hedge funds, which typically charge 1 percent to 2 percent of assets under management. The lack of that fee made Bayou funds attractive, several investors said.

Today, lawyers representing various parties involved in the Arizona matter are expected to be in court there for the hearing regarding Mr. Israel's motion to have the $100 million released. His lawyers, who have just quit, have argued that Arizona has no jurisdiction over the money.

It is unclear how the departure of Bayou's lawyers will affect the pending motion. Judge Colin Campbell will have to juggle two motions: one in which Mr. Israel's lawyers argue that Arizona authorities have no jurisdiction to seize the funds and one in which the lawyers quit the case.